The past week or so has shown yet again that no one really knows anything. The sudden collapse and bailout of Silicon Valley Bank and a couple of other small US banks came out of the blue. So did the need for the Swiss central bank to step in and pledge support to Credit Suisse, even if it has been in trouble for some time. This weekend urgent efforts are underway to engineer a merger with the other big Swiss lender, UBS. Maintaining the confidence of depositors is, as ever with banking, the vital goal.
And who would have foreseen that as it increased interest rates again this week, the European Central Bank would have to pledge that it stands ready to provide liquidity to the euro zone banking sector if needed, even though it believes the sector is resilient and well-capitalised? With ECB vice-president Luis de Guindos reportedly telling EU finance ministers in private that some euro zone banks might be vulnerable, this story does not look like a one-week wonder.
Sometimes we think that “the markets” know all this stuff. But the swings in expectations of future interest rates were so sharp this week that it is clear that traders are as surprised and confused as the rest of us. Nobody saw the problems in an obscure part of the UK pensions market before they exploded last year – albeit spurred by an incompetent budget – and few anticipated that we are now watching what Larry Fink, the head of Blackrock and one of the world’s biggest money managers, called a “slow rolling crisis” in the US financial system. In turn, this would keep nerves on edge in Europe.
The other lesson of the week is that big organisations respond to incentives. The ECB decided to push ahead with a half-point increase in interest rates this week because its key mandate is to get inflation down to 2 per cent. Its president, Christine Lagarde, said it was closely monitoring the “transmission of monetary policy”, which is jargon for saying it hopes the higher interest rates are passed on to businesses and personal borrowers. But it also promised to supply funds to the euro zone banks if needed, because its other key objective is to maintain a stable financial system. The punter gets squeezed, in other words, to keep inflation down, but the banks are kept afloat to avoid financial turmoil.
Its problem in the months ahead is that the inflation objective may call for yet higher interest rates, while the need for banking stability may point to cuts or a pause. Unwinding the years of loose monetary policy, including super-low interest rates, was never going to be easy. There was always the threat of triggering a recession by moving too far, too fast – and the risk that meeting the inflation target might even require this.
But now the law of unintended consequences has raised its head as well. Banks are making losses on the market value of their holdings of government bonds, which have fallen sharply in price. as interest rates rise. Who knows what other delights may be triggered in the bowels of banking and the financial system as rate rises continue – and while they remain low by historical standards, the pace of increase is unprecedented in recent years.
Bank regulation has moved on a lot and financial experts believe that in general European banks should be able to weather what is ahead. But no one saw this one coming and, as always happens when one or two banks fail, the other green bottles will be nudged to see if any of them look shaky as well. In Ireland, the Central Bank not only has the domestic players to worry about, but also the activities of the international funds sector in the IFSC.
Does this law of unintended consequences offer any hope to Irish mortgage holders? It might, though in the spirit of no one knowing anything, this is not yet clear. The drumbeat from the ECB had pointed towards further significant increases beyond the one just announced, perhaps as much as another one percentage point, which would bring the total rise to a very hefty 4.5 points.
Now it looks more uncertain. Some analysts are likening the latest increase to one in 2011, in the midst of the financial crisis. This may not be fair – the banks do not, in general, have the same vulnerabilities as they did back then. But the cracks starting to appear indicate other potential problems and if recession takes hold bad debts could again be a problem. As this plays out, ECB interest rates could top out at a lower than earlier anticipated, When they might then start to decline is, then, another question and one very difficult to predict. That is probably quite some way off yet.
In the US, there is talk of interest rates actually falling later this year, though they may rise again before this happens. The ECB is confident that euro zone banks are in better shape and thus seem to be pressing on with higher interest rates, but the language of their statement on Thursday did give them a bit more room for manoeuvre. This is sensible, but whether the more hawkish members of the governing council can be persuaded to tow the party line that things will be decided on a meeting-by-meeting basis remains to be seen. The ECB is a house divided and what it does next will now very much depend on whether the market turmoil extends or starts to calm. Its council would do well to remember that banking is a game of confidence and it now needs to tread carefully because if deposits start to leak away from other parts of the banking sector, there will be trouble.
With politicians assuring us that our banks are safe, international tremors and property prices starting to slip, there are echoes here of the run up to the financial crash. And this does pose a threat to international economic growth and may raise questions about confidence and financial stability. The stronger state of Irish banks and household finances give some cause for confidence here – bank loan books do not have the same horrendous exposures to overvalued property as they did in 2008 and are full of depositors’ cash. But higher interest rates are taking a toll, international markets are nervous and the next few months look like they could be bumpy.